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The Risks Surrounding Brexit Can Be Found in U.K. Bond Markets

(Bloomberg) -- The pound may have been relatively calm in recent weeks, but U.K. bond markets are seeing signs of Brexit-induced distress.

Investors have been flocking to the safety of longer-dated gilts, preferring them over shorter maturities, a sign that they think the risks surrounding the economy are growing. At the same time, they are betting that inflation will become a headache for policy makers, a scenario that is likely if the U.K. were to tumble out of the EU without a deal, sending the pound plummeting and the costs of imports soaring.

That would also mean the Bank of England may be forced to raise borrowing costs to quell surging inflation. Currently, traders in money markets aren’t betting on a hike until March 2020.

Here are three charts that show how the U.K. rates markets are bracing for uncertain Brexit outcomes:

Flattening Curve

The U.K. government bond curve possibly best reflects the concern over the potential economic impact of Brexit. The yield premium on 10-year securities over two-year ones has dropped to its lowest level since 2016 as investors seek the safety of longer-dated debt.

Mizuho International Plc is recommending that investors position for further flattening of the curve, and sees room for the two- to 10-year spread to reach 10 basis points, a level not seen since the global financial crisis.

“Parliament remains in stalemate and the clock is ticking,” said Peter Chatwell, head of European rates strategy at the bank. “Curve flatteners will come back to the fore.”

Inflating Risks

The threat of a no-deal exit from the European Union remains alive in the nation’s inflation markets. The five-year, five-year inflation swap rate, a gauge of how fast the market expects prices to rise, has touched 3.7 percent this month, close to a two-year high. That’s in spite of a report Wednesday showing price growth slowed toward the BOE’s 2 percent target.

Unlike the euro area where dwindling price expectations reflect an outlook for slower growth, the surge in the U.K. is fueled by the prospect of a rapid increase in import prices should the nation crash out of the EU on March 29 without any agreement. The BOE has said it may be forced into increasing interest rates under such a scenario.

BOE on Hold

Traders currently don’t expect the U.K. central bank to raise rates in 2019. That could change dramatically should a Brexit pact be reached, with JPMorgan Asset Management saying that a U.K.-EU agreement could rapidly herald two rate increases by the BOE this year.

The prospect of a deal “changes the outlook for the Bank of England this year, assuming the world economy is not falling out of bed,” Karen Ward, JPMorgan Asset’s chief market strategist, said at a press briefing last week in London. “We should see Bank of England rates 50 basis points higher by the end of the year.”